July 6, 2022
The turbulence experienced by financial markets in the first three months of the year continued in the second quarter, with the S&P 500 falling 16%. The TSX, which had posted decent returns in the first quarter thanks to a 27% gain in the energy sector, fell 14% as the oil and gas sector retreated in the second quarter. And while bonds usually provide some ballast for portfolios during turbulent times, for the second quarter in a row, bonds fell alongside their equity counterparts. It has been the most challenging first six months to a year that investors have experienced in decades.
What has happened?
Of course there are a number of factors for the weakness, but one of the driving forces has been persistent inflation. Prices had been rising before Russia’s invasion of Ukraine, but subsequent export sanctions on Russia’s commodities exacerbated the situation. Adding fuel to the inflation fire has been ongoing supply chain issues, including China’s strict COVID restrictions, which have impacted exports from that country.
Central banks are trying to tamp down on inflation by raising interest rates at a pace not seen since the early ‘80s. Rising interest rates, of course, hurts bond prices. But they also cause price-to-earnings multiples on stocks to contract and the expensive technology stocks have been most sensitive to this phenomenon, leading them to be the worst-hit equity sector this year.
When combined with the high cost of oil and gas, some fear rising interest rates could spark a recession. This has impacted stocks in the financial, industrial and consumer discretionary sectors of late.
Could a recession be coming? Is that even the right question to be asking?
Since there is no evidence that the business cycle has become a thing of the past, the debate about whether or not there will be a recession misses the mark, in our view. There is a 100% probability of a recession at some point in the future. The real uncertainty is not if, but when it will occur. Our base-case expectation is that the rising interest rates will have their typical delayed effect, resulting in a recession that begins in mid-2023. But we realize that such forecasts are fraught with uncertainty. Moreover, we do not believe that one should make drastic portfolio changes if a modest, “garden-variety” recession were to begin over the next year or so.
A more relevant question — the answer to which could require more drastic portfolio shifts — is: what is the likelihood that instead of a modest recession, we experience another financial crisis? In our view, a calamity on the level of the 2008-09 recession (which led to a stock market decline of more than 50%) is highly unlikely for a number of reasons. First and foremost, global banks are in a far better position to weather the loan losses that are caused by a steep economic contraction. In an effort to avoid a repeat of the harmful credit crunch that occurred in 2008-09, regulators implemented stress tests on all banks to ensure they have enough capital to withstand a severe and prolonged recession.
Source: US Federal Reserve
In addition to the improved bank balance sheets, US consumers also have much lower debt levels today as compared to the period preceding the US housing crisis. The labour picture also remains favourable, with the US unemployment rate close to all-time lows and hourly wages rising more than 6% year over year. While things could change over time, it is hard to envision a near-term financial crisis when most people are able to find a job and win wage increases.
Where to from here?
So if we can remove the worst-case scenario of a financial crisis from the list of likely outcomes, what does that mean for the stock market? Typically, the stock market tends to fall about 20% during a non-crisis recession. That suggests that the vast majority of the implications from a recession may already be priced into stocks.
The upcoming earnings season that begins in a couple weeks will be important, however. It is possible that companies lower their earnings outlooks due to persistent supply chain issues, currency impacts and input-cost inflation. As such, we could experience a few more weeks of volatility.
Reasons for optimism
While there is further uncertainty in the near term, there are several reasons for optimism. The first is the fact that many investors are very negative on the outlook for stocks – this has historically been a good contrarian indicator. The American Association of Individual Investors conducts a weekly survey of its members. Over the past 12 years, when more than 48% of them have said they were bearish on stocks over the next six months, it has resulted in very strong one-year returns for stocks. Since this “buy signal” was first triggered in late January, the S&P 500 index has fallen 11%, but that can likely be attributed to the unexpected events in Ukraine and the resulting sanctions on Russia. More recently, 59.3% of survey participants said they were bearish. The only other time we have seen that level of bearishness was in October 2008, when there were fears that the global banking system could collapse. No such risk appears evident today.
Source: American Association of Individual Investors
One group of investors that is bullish, however, is corporate insiders. Executives are personally buying shares in the companies that they work for at a pace only seen during recent market bottoms, including early 2016, early 2019, and mid-2020. This signals that while there may be some near-term challenges, those that are most in tune with the long-term direction of corporate profits are taking the stock market decline as a buying opportunity.
Corporate Insiders are Bullish
Source: JP Morgan
Potential Catalysts
With so much negativity amongst the broad investing public, it is possible that any further economic or earnings news could be met with an asymptomatic response. For example, further interest rate hikes or earnings shortfalls could be met with a shoulder shrug as those might not change the dominant market narrative in any way.
Any positive news, however, could be met with a very quick rebound in stock prices. One such catalyst would be a sign that inflation is starting to cool. Commodity prices such as oil and natural gas have started to level off; others, such as lumber and copper are already down sharply from their peaks. Further declines, combined with any supply chain improvements, could signal that we have turned the corner on inflation and that the central banks can ease up on rate hikes.
Source: Refinitiv
Any positive news on the Russia-Ukraine conflict would also likely meaningfully shift investor sentiment. We do not expect a quick resolution to the war, but that is already the conclusion most have come to. If, on the other hand, the two sides were to start meaningful negotiations that could lead to an easing of the economic sanctions and a reopening of Ukrainian wheat exports, inflation fears could be calmed further.
Investing through the uncertainty
We have not stood still during the evolving macroeconomic environment. The headwinds presented by rising interest rates have led us to reduce some exposure to more expensive technology stocks and banks, the latter of which are exposed to a slowing housing market. Instead we have increased exposure to the more resilient consumer staples and health care sectors of the market.
Now that most stocks on the TSX and S&P 500 have lost at least a quarter of their value from their 52-week highs, we are identifying high-quality companies whose share prices appear to be pricing in a deep and prolonged recession. Many of these companies have strong balance sheets that will not only allow them to survive an economic downturn, but will likely help them come out in a stronger position than their more indebted competitors.
Stocks Have Been Resilient Over Time
Regardless of whether or not a recession begins next year, later this year, or has already begun, a 20% decline in stocks has historically been a good time to buy stocks for long-term oriented investors, even if there is further near-term weakness. The issues of the day often seem insurmountable in the moment but tend to moderate in consequence over time. Over just the past 40 years, financial markets have been witness to wars, pandemics, financial crises, inflation spikes, oil embargos, terrorist attacks, speculative bubbles and natural disasters. While there have been notable short-term bumps along the way, over time stocks have generated impressive returns for investors who maintained the long-term view. With that mindset, we will continue to try to block out what we believe is noise and focus on identifying attractive investing opportunities.